Christopher Mayer, a commercial loan officer, is studying for an MBA at the University of Maryland.
Gadflies have long been predicting the exhaustion of critical natural resources—especially oil. Despite the doomsaying, a barrel of oil is cheaper today than a pair of movie tickets.
As Daniel Yergin pointed out in a recent editorial in the Wall Street Journal, “prices, in inflation-adjusted terms, are at a level that has not been seen since 1973, prior to the oil embargo and the first oil crisis.” In addition, the cost of exploring and developing crude is now only about $5 per barrel compared with over $21 per barrel in 1982.
Any cursory review of the history of real oil prices will show a long downward trend. It would seem oil is getting less scarce. And it would seem that there is no reason for this trend not to continue. This line of reasoning is vigorously pursued in the late Julian Simon’s book The Ultimate Resource 2.
With oil prices at record lows, it is perhaps appropriate to reflect on the triumphs of markets and the erosion of the power of OPEC, the Organization of the Petroleum Exporting Countries. OPEC is often thought of as an Arab organization, but four of the 11 members—Iran, Nigeria, Venezuela, and Indonesia—are not Arabic. (See www.opec.org.) That’s not the only misconception about OPEC.
Low oil prices persist despite OPEC’s best efforts to support a higher price. In fact, market forces have made OPEC a paper tiger. Alan Abelson of Barron’s astutely noted that years ago “In contriving to push up the price so precipitously, it inspired a frantic hunt for new deposits of oil and gas and, at the same time, set off formidable efforts at conservation. Which, of course, is the way markets inevitably work.”
Services, Not Substances
Oil is used more efficiently today, and new sources are constantly being found. Importantly, substitutes for oil are also being developed and used. Remember, it is not oil itself that concerns us. Rather, it is the services that oil provides that are important. We should not care if, in a highly unlikely and theoretical scenario, we ran out of oil, as long as the service that oil yields is provided just as adequately by some substitute.
The world’s experience with the energy crisis is consistent with deductive theory regarding the essential role of market prices in mobilizing economic forces to best provide for consumers’ most urgent wants. As Simon wrote in The Ultimate Resource 2: “Heightened scarcity causes prices to rise. The higher prices present opportunity, and prompt investors and entrepreneurs to search for solutions. Many fail, at cost to themselves. But in a free society, solutions are eventually found. And in the long run the new developments leave us better off than if the problems had not arisen.”
We are better off because the market process yields more goods that cost less. Of course, for this type of activity to occur, people must have the freedom to employ their capital as they wish. The market process must be allowed to work free of government meddling. This goes against the conventional wisdom that when energy prices rise, government should induce conservation. (See the preceding article by Ben Lieberman.)
OPEC as Cartel
Can’t OPEC wield cartel power? Economic theorists have long recognized the unstable nature of cartels. A cartel is an organization of separately owned producers cooperating, often through quotas on production, to achieve a price above what the free market would have chosen. On a free market, these arrangements fail because of the market forces they set into motion.
Simon pointed out that “A cartel such as OPEC, whose members have differing interests, is subject to pressures that make it difficult to maintain whichever price maximizes profit for the cartel as a whole. There is a great temptation for individual countries to sell more than their quotas.”
The problems inherent in any cartel can best be illustrated by the prisoner’s dilemma. Sharon Oster, in her book Modern Competitive Analysis, writes that in the prisoner’s dilemma, “the payoffs are such that both players have individual incentives to choose strategies that together give both players a worse outcome than if both players had simultaneously chosen the other strategy.”
To illustrate, say two prisoners are separated and told that if one confesses to a joint crime, both will be convicted, but the confessor will get a light sentence, say, one year, while the other prisoner will get ten. If neither confesses, they each will get two years. Individually, their incentives are to confess to serve the shortest time imprisoned. Jointly, it would be best if both kept quiet. This was a good approximation of the situation faced by OPEC, when it had a better grip on the world’s supply of oil.
Some critics point to the fact that OPEC is still the low-cost producer and if oil prices continued to fall, OPEC would regain market share and its monopoly power.[1] I would first point out that the more oil prices fall the greater boon for oil consumers. Also, the fact that oil prices could fall further is a reflection of increased supply or slackening demand on the free market (ignoring money-induced changes or government price-fixing), neither of which would be cause for concern if we believe that market prices transmit valuable information regarding efficient resource allocation. We shouldn’t care who produces the oil, only that we can purchase it when we need it. I am reminded of Bastiat, who made the point this way:
Suppose someone tells you: “It is essential for a great country to have an iron industry.”
Answer: “What is more essential is that this great country have iron.”[2]
OPEC wouldn’t be helped by expanding to include American producers. There will always be an incentive for the better producers to cheat on the cartel.
The abundance of oil today is a testament to the ability of prices to send signals to entrepreneurs about consumers’ most urgent wants. It is an illustration of the market’s ability to organize and deliver goods efficiently. And finally, it shows that in a free market, there is no such thing as monopoly power, for it will not be long before the monopoly that attempts to defy the market is broken. As Horace said, “Many shall be restored that are now fallen and many shall fall that now are in honor.”
Notes
- Ron Chernow, “No Funeral for OPEC Just Yet,” (New York Times, January 5, 1999). Chernow makes the point that the cost of extraction is only $2 per barrel for OPEC, versus $7 per barrel for “super-efficient” Exxon on domestic oil and more than $10 per barrel on foreign oil.
- Frederic Bastiat, Economic Sophisms, from the essay titled “The Little Arsenal of the Freetrader” (Irvington-on-Hudson, N.Y.: Foundation for Economic Education, 1964), p. 251.
Christopher Mayer
Paul Milstein Professor of Real Estate at Columbia Business School, where he is also the Research Director of the Paul Milstein Center for Real Estate. In addition, he has also been a Visiting Scholar at the Federal Reserve Bank of New York, and Research Associate at the National Bureau of Economic Research.